by James A. Bacon
To understand America’s fiscal future, it is instructive to look at Italy. The land of la dolce vita has the 8th largest economy in the world and, by some measures, the 8th highest standard of living. The country also has one of the largest government debt loads in comparison to the size of its economy. That’s equivalent to about 120% of GDP, higher than that of the United States, which is about 100% of GDP. On the other hand, Italy’s deficits are smaller than the United States’ as a percentage of GDP, and now that Prime Minister Berlusconi has announced his intention to resign, the country does seem poised to pass genuine budget reforms.
But it may be too late. Interest rates are climbing as investors, spooked by the prospect of massive losses in Greece, demand a higher risk premium for Italian debt. Interest rates on 10-year Italian bonds have shot up to roughly 7% — roughly twice that of the United States. Italy now confronts a situation where it literally may be unable to raise taxes/cut spending fast enough to offset the higher interest payments.
A new report by Barclay’s Bank suggests that “Italy may beyond the point of no return.” It is entering a “fiscal event horizon,” at which point the gravitational force of the black hole of debt is so powerful, there is no escaping its pull. Writes Barclay’s: “We doubt that Italian economic reforms alone will be sufficient to rehabilitate the Italian credit and eliminate the possibility of a debilitating confidence crisis that could overwhelm the positive effects of a reform agenda, however well conceived and implemented.”
As interest payments mount, deficits worsen. As deficits worsen, investors demand higher risk premiums. As investors demand higher risk premium, interest rates and interest payment shoot even higher.
Right now, the United States is the beneficiary of the euro crisis. Risk-averse investors are parking their money in U.S. Treasuries. As a result, interest rates here remain astoundingly low. Those low rates have bred a sense of complacency. Yeah, we know that budget deficits are out of control, but it’s not like we’re in an emergency situation yet. But Italy shows how quickly investor psychology can change. Borrowing costs there have surged from 4% to 7% in one year.
For the United States, which is laboring under $15 trillion in debt, a comparable increase in interest rates would be very troubling indeed. Currently, the nation expects to pay $242 billion in interest on the national debt — big but manageable. Increase the interest rate by 75%, as happened in Italy, and the number rises to $423 billion (although not right away, given the fact that many bonds will take years to roll over). Scary, but still manageable.
It’s a different story when we reach 2021. According to Office of Management and Budget forecasts, absent major changes in legislation, interest payments will reach $844 billion by 2021 due to (a) a bigger national debt and (b) the somewhat higher interest rates that attend the mature phase of a business cycle.” But tack on a 3 percentage-point risk premium like the Italians are experiencing, and we’ll add nearly $570 billion extra a year in interest payments. The following year, just the interest on the extra interest would amount to roughly $45 billion! Clearly, that is unsustainable.
Basically, without massive budget reform, we’re about 10 years behind Italy. Boomergeddon is running ahead of schedule. Batten down the hatches while we still can!
